The Summer of Uncertainty

Just as emerging markets are recovering, developed markets are losing steam, a lack of synchronicity that means slower growth, leaving investors trying to figure out how to rebalance.

Brexit, the U.S. election cycle, China’s slowdown, and waning effectiveness of monetary policy. These are just some of the factors intensifying political and policy uncertainty, which has emerged as a fresh headwind to the global economy—enough to keep growth subdued both this and next year.

In their latest assessment of the global economy and markets, Morgan Stanley’s economists and strategists see plenty for policy makers, businesses and investors to worry about. Just as emerging markets as a whole seem to be recovering momentum, developed markets are losing steam, a lack of synchronicity that will mean slow growth and force investors to re-evaluate their strategies, even though many markets and asset classes have performed quite well year to date.

“Reflecting the multiple headwinds buffeting the global economy, we expect global growth to decelerate in the second half of 2016 and remain relatively subdued until the first quarter of 2017,” write Chetan Ahya and Elga Bartsch, co-heads of global economics for Morgan Stanley, in their recent report, “Global Macro Summer Outlook: Clouded by Politics and Policy Uncertainty.” They expect central banks to go with the flow of easy monetary policies that have dominated global markets in recent years but the fiscal policy response, which is more critical now, will be hesitant due to the political cycle in the UK, Europe and US.

We expect developed market growth to decelerate from 1.9% in 2015 to 1.4% in 2016, and further to 1.2% in 2017.

Fed Moves to the Sidelines

Case in point, the U.S. Federal Reserve, which finally raised its key rate last December and, until recently, had indicated its resolve to tighten further this year, now is expected to stay on the sidelines. “We believe there are enough signs to suggest the U.S. economy has moved into the late phase of its business expansion,” says Ellen Zentner, Morgan Stanley’s chief U.S. economist. Zentner, who was the only major Wall Street economist to call the Fed’s action last year and originally expected an additional increase late in 2016, now expects the Fed to take no action this year—or next.

Apart from the Fed, Morgan Stanley expects the European Central Bank to extend its quantitative easing (QE) program by six months, to September 2017, and the Bank of England to cut UK rates by 40 basis points by the end of August and reactivate its own QE program later this year.

Consumers have largely done their part to support growth. “At an aggregate level, the developed market consumer has been a key support to growth over the past two quarters,” says Bartsch. However, businesses remain cautious, with private capital expenditure, already below the historical norm, showing renewed signs of weakness, she adds. Meanwhile, the increased uncertainty after Brexit and from other looming political events will likely weigh on growth in developed markets. “We expect developed market growth to decelerate from 1.9% in 2015 to 1.4% in 2016, and further to 1.2% in 2017,” Bartsch says.

In the U.S., growth is expected to decelerate to 1.5% in the third quarter, and stay close to but below that rate over the forecast horizon. Morgan Stanley expects a technical recession to hit the UK in the second half of 2016, and a sequential contraction in growth in the euro area in the third quarter; however, economic activity will likely pick up in the first quarter of 2017. Meanwhile, in Japan, “real growth has likely stalled in 2016, but we do expect a modest pick-up in 2017, particularly as the increase in fiscal spending kicks in,” says Ahya.

Emerging Markets to Rebound

The outlook is brighter for emerging markets, where the commodities drag has faded. Morgan Stanley expects growth to improve from 4.0 % in 2016 to 4.7% in 2017. Since 2013, “emerging markets, excluding China, have had to adjust to a stronger dollar and the increase in U.S. real interest rates, along with slower growth in China and its attendant impact on commodity prices and trade, and the unwinding of their domestic sources of misallocation,” says Ahya.

Morgan Stanley now expects Russia and Brazil to transition from recession to modest levels of sustained growth starting in the fourth quarter. India should see steady growth and a broader recovery, as consumption growth improves. “China’s growth trajectory, however, will likely remain in a downward cycle, as the effect of past stimulus fades and structural headwinds weigh on domestic demand,” says Ahya.

Two Themes for Second Half

How should investors approach all of this uncertainty in an out-of-sync world? “Before you despair,” says Andrew Sheets, Morgan Stanley’s chief global cross-asset strategist, “remember that many markets have already done well this year.” Yet, he also counsels staying realistic: “We wholeheartedly agree that easier fiscal policy makes good economic sense and would drive markets higher with healthy rotation. We just don't think we'll get it in a meaningful way over the forecast horizon, given gridlocked U.S. politics, a lack of flexibility in the European Commission, and the expected size of Japan's easing.”

Sheets urges investors to focus on two themes in the second half of 2016. “A rotation toward 'quality carry,' which we see as well-suited for our forecasts of weaker growth but looser policy, and relatively better performance from emerging markets.” His playbook for the rest of the year includes “a shift exposure from corporate to securitized credit, while adding to emerging market equities and local rates.

Sounding a tad wistful, he adds: “We see quite a bit that is mispriced and under-owned if global growth beats expectations in the second half.” And indeed, Sheets and his team offer some alternative upside scenarios where global growth picks up if the impact of political events turns out to be more benign, if developed market consumer spending holds up better, or if the emerging market recovery gathers more speed and momentum. But these also to some extent hinge on just-right timing and the magnitude of policy makers’ fiscal response. In other words, the world would have to fall back in sync.